In his inimitable, humorous fashion, Chris Hoyt, professor of law at the University of Missouri-Kansas City School of Law, shared some helpful strategies for making charitable gifts that save income as well as estate taxes at the 53rd Heckerling Institute conference.
First, Professor Hoyt explained how donors can get tax savings from charitable gifts when they are not able to itemize deductions, an increasing problem for many taxpayers. As a result of the Tax Cuts and Jobs Act of 2017, he noted that the estimated number of itemizers has dropped from 37 million to 16 million, largely due to the $10,000 cap on the state and local tax deductions and the increased standard deduction.
Charitable IRA Rollover
This is a very helpful lifetime strategy for older philanthropic donors. With an IRA charitable rollover, the donor does not have a charitable deduction but does not include the amount of the charitable distribution in income, effectively the same result as a deduction.
There are seven requirements for a successful IRA charitable distribution:
- The donor must be over age 70½
- Annual charitable distributions cannot exceed $100,000, regardless of the required minimum distribution, and would be a taxable distribution if not paid to charity
- The distribution can only be from an IRA (including an inherited IRA), not from other pension vehicles
- The distribution must go directly to the qualified charity (including by use of an IRA checkbook issued by a brokerage house)
- The donor cannot receive any benefit from the charity, such as attendance at a gala
- The distribution must be to a public charity, private operating foundation or certain conduit foundations, but not a private nonoperating foundation, donor advised fund or supporting organization
- The donor must receive a contemporaneous acknowledgment from the charity for gifts of $250 or more
Who benefits:
- Donors not able to deduct charitable gifts from federal income tax
- Donors seeking to reduce adjusted gross income; for example, to remain below the $200,000 ($250,000 for married) threshold for the 3.8 percent surtax on net investment income or to reduce Medicare B premiums
- Donors in states that don’t provide income tax charitable deductions
- Donors who have made gifts exceeding the 60 percent adjusted gross income limitation
- Donor’s family, who can inherit assets with a stepped-up basis, rather than IRA assets subject to income tax
Who doesn’t benefit:
- Donors in states that don’t tax IRA benefits
- Donors about to sell appreciated securities who could gain a greater tax advantage from donating those securities and saving the capital gains taxes that would otherwise be due
The IRS will permit donors to fulfill a charitable pledge through an IRA charitable distribution, without incurring income for payment of indebtedness or being subject to self-dealing rules.
Income Tax Deductions for Charitable Bequests of IRD
Professor Hoyt then discussed whether an estate or trust can take a charitable contribution deduction for transfers of income in respect of a decedent (IRD).
He asked and answered four questions:
What is IRD? Simply defined, IRD is a payment received after death that would have been taxable if received by the decedent before death. The most common IRD assets are IRA and pension assets. These assets are subject to both the estate tax, when applicable, and to income tax as IRD.
Is it possible to obtain both estate and income tax deductions for charitable bequests payable from pension benefits? The answer is a resounding yes under Treasury regulation section 1.642(c)-3(a).
Do the 2012 substantial economic effect regulations apply to eliminate a charitable income tax deduction? The answer is no, as the regulations cover only the character of income, not the charitable deduction.
Will a pecuniary bequest trigger a taxable gain to the estate? Yes, if the bequest is satisfied by distribution of appreciated property triggering capital gain. But if the distribution is made to charity out of gross income pursuant to the governing instrument, the estate will have an offsetting charitable deduction, per Rev. Rul. 83-75.
Professor Hoyt went through a case study comparing the tax consequences of a charitable bequest.
First approach: a simple charitable bequest. Because it is payable on date of death, it cannot be made out of income and therefore receives only an estate tax deduction.
Second approach: a direction to pay a charitable bequest from income from the estate. Because the bequest is paid out of income earned after death, the estate gets an income tax deduction but no estate tax deduction.
Best strategies: First, if donating pension or IRA assets, name a charity in the pension plan or IRA beneficiary designation form. This way, the transfer is made outside of the estate, and income is payable to a tax-exempt entity.
Second, include boilerplate language in the estate plan providing for charitable distributions to be made from IRD and from gross income generated by paying a pecuniary obligation, to obtain the benefit of the section 642(c) deduction. Unlike the individual deduction, trusts must have a governing instrument provision providing for payments from gross income to obtain the charitable deduction. Warning: There may be situations where this general instruction will need to be overridden by specific instructions not to pay IRD to the charity, for example where the estate is payable to a stretch IRA or to a QTIP.
Income-Based Charitable Bequests
Professor Hoyt discussed the two-tier income taxation for distributable net income (DNI) and the difficulty in obtaining a charitable deduction when individuals receive mandatory income.
He pointed out that many estate planners are continuing to draft bequests for estate tax deductions, but with most estates below the exemption, the charitable income tax deduction may be more important. He offered three guiding principles for estates not subject to estate tax:
First, make lifetime charitable gifts.
Second, make charitable bequests from IRD assets.
Third, include language in the governing instrument requiring charitable bequests first from IRD and second from gross income generated by making a pecuniary distribution.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, investment, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
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